Bond yields confound forecasters

The bull run might not quite be over yet
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Markets have an uncanny ability to make fools of even the brightest prognosticators, and 2016 is shaping up to be another year to frustrate Wall Street’s supposedly finest forecasters.

The global bond market has enjoyed a remarkable rally since Paul Volcker, former chairman of the US Federal Reserve, managed to squash inflation in the 1980s. Bond yields, which move inversely to prices, have dropped lower and lower since then, and investors have enjoyed enviably steady returns.

Strategists have long predicted that the end of the great bond bull market was nigh. They point to events such as the end of the Federal Reserve’s “quantitative easing” programme in 2013 and its decision in December to raise short-term interest rates by a quarter of a point — the first upward move in nearly a decade. Indeed, last year the Barclays Global Aggregate, a widely-followed bond index, lost over 3 per cent — its worst performance in a decade — handing further ammunition to analysts that saw a reversal in the multi-decade decline in bond yields.

“The bonds of major advanced economies remain ‘expensive’ relative to levels consistent with our economists’ views on growth, inflation and the policy stance,” Francesco Garzarelli, co-head of macro and markets research at Goldman Sachs wrote in his 2016 outlook.

But this year’s market turmoil has led investors to flock back to the safety of fixed income, pared back expectations for how aggressively the Fed will raise interest rates and ramped up speculation that the European Central Bank and the Bank of Japan will ease monetary policy further. This has combined to produce a forecast-busting bond rally.

The US 10-year Treasury yield, one of the most widely watched benchmarks in the world, has fallen back to well below 2 per cent again, the equivalent German bond yield is close to zero, and the 10-year Japanese government bond yield recently made history — and defied centuries of economic orthodoxy — by falling into negative territory.

Few saw this coming. At the start of the year only two of 73 analysts polled by Bloomberg predicted the 10-year Treasury yield would fall below 2 per cent again, but the rally has been broad and international. The average yield of the Barclays Global Aggregate index has fallen back down to about 1.5 per cent — within a whisker of a new record low. No wonder that as George Eliot noted in Middlemarch: “Among all forms of mistake, prophecy is the most gratuitous.”

Despite seeing their forecasts unravel this year, most analysts are still predicting that bond yields will climb in the coming months and years. According to recent surveys conducted by Bloomberg, strategists forecast that the 10-year US, German, UK and Japanese bond yields will rise to 2.55 per cent, 0.89 per cent, 2.38 per cent and 0.13 per cent respectively by this time next year. Some big-name investors are even punchier. Michael Hasenstab, the high-profile chief investment officer of Templeton Global Macro, argues that the pervasive pessimism that has enveloped markets this year is overdone and warns that the return of inflation is still the biggest danger.

“The weight of . . . evidence suggests that it would take a set of heroic assumptions to believe that inflation will remain at the current extremely low levels,” Mr Hasenstab wrote in a report to his clients in February. “We believe financial markets are underestimating the potential for a rise in US yields.”

However, some other well-known analysts and money managers continue to caution that repeated warnings that the bond bull market will soon end will once more come to naught.

Several major central banks are now not just dabbling with buying bonds but even negative benchmark interest rates, which makes the positive-yielding government debt even more attractive, and yet more stimulus could be on the cards from the Bank of Japan and the European Central Bank.

The Swedish Riksbank was first to experiment with negative interest rates in 2009. With the Bank of Japan joining the club earlier this year, almost a quarter of the global economy now has negative interest rates. That has pushed the value of negative-yielding government bonds to over $5tn this year, and transformed the outlook for the rest of the year.

Steven Major, global head of fixed income research at HSBC, was one of the few strategists who accurately predicted last year that bond yields were not about to shoot up.

He has forecast that the US, German and Japanese 10-year yields will end the year at 1.5 per cent, 0.2 per cent and 0.3 per cent. Even that may be too sanguine, the strategist recently warned.

While there are mounting doubts over the efficacy of negative interest rates — primarily due to the challenges they pose to the global banking system — Mr Major argued in a recent report that investors are underestimating the willingness and ability of central banks to move their benchmark rates even further below zero. This could push bond yields even lower.

“Markets do not seem to believe that rates can fall much further. Forward rates imply only small shifts lower in those headline rates already in negative territory. But the markets may be wrong,” he wrote. “We are not changing our bond yield forecasts but our analysis suggests there is growing risk rates could still go lower.”

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